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Does the level of capital formation track the level of derivatives outstanding? Were derivatives being written as hedges on "real assets"? Or were they being used as speculative products? Graph source: Adam S. Posen and Marc Hinterschweiger

See also Credit default swaps, CDS clearing, CDS confirmation, CFTC, Derivatives concentration, ***House derivatives 2009***, muni swaps and regulatory harmonization


Congressional overhaul of derivatives market complete

“The Wall Street reform bill will – for the first time – bring comprehensive regulation to the over-the-counter derivatives marketplace. Derivatives dealers will be subject to robust oversight. Standardized derivatives will be required to trade on open platforms and be submitted for clearing to central counterparties. The Commission looks forward to implementing the Dodd-Frank bill to lower risk, promote transparency and protect the American public.” - CFTC Chairman Gary Gensler


As a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the CFTC will write rules to regulate the over-the-counter derivatives marketplace. The CFTC has identified 30 areas where rules will be necessary. The public is encouraged to provide input on the rule-writing process. Information regarding each rule-writing area will be published as it becomes available.

See List of OTC Rulemakings


The Dodd-Frank Wall Street Reform and Consumer Protection Act brings comprehensive reform to the regulation of over-the-counter derivatives. These products, which have not previously been regulated in the United States, were at the center of the 2008 financial crisis. The historic Dodd-Frank bill authorizes the CFTC to:

Regulate Over-the-Counter Derivatives Dealers

  • Derivatives dealers will be subject to capital and margin requirements to lower risk in the system.
  • Dealers will be required to meet robust business conduct standards to lower risk and promote market integrity.
  • Dealers will be required to meet recordkeeping and reporting requirements so that regulators can police the markets.
  • Increase Transparency and Improve Pricing in The Derivatives Marketplace

Instead of trading out of sight of the public, standardized derivatives will be required to be traded on regulated exchanges or swap execution facilities.

  • Transparent trading of over-the-counter derivatives will increase competition and bring better pricing to the marketplace. This will lower costs for businesses and their consumers.
  • Lower Risk to the American Public

Standardized derivatives will be moved into central clearinghouses to lower risk in the financial system.

  • Clearinghouses act as middlemen between two parties to a transaction and take on the risk that one counterparty defaults on their obligations.
  • Clearinghouses have lowered risk in the futures marketplace since the 1890s. The Dodd-Frank bill will bring this crucial market innovation to the over-the-counter derivatives marketplace.

I. Introduction

On July 15, 2010, the U.S. Senate passed by a 60-39 vote the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), following earlier passage of the legislation by a 237 to 192 vote in the U.S. House of Representatives on June 30, 2010. On July 21, 2010, President Obama signed Dodd-Frank into law.

Dodd-Frank constitutes the most sweeping financial reform package since the 1930s. Title VII of Dodd-Frank, the Wall Street Transparency and Accountability Act of 2010 (“Title VII”), brings about a complete overhaul of the OTC derivatives market in the United States. The primary objectives of Dodd-Frank are to bring about greater transparency and to enable U.S. regulators to better manage individual counterparty and broader systemic risks that are inherent in the OTC derivatives market.

The enactment of Dodd-Frank will not be the final word on the reform of derivatives. Regulators will promulgate several dozen regulations to implement Dodd-Frank, and Congressman Barney Frank (D-MA) recently stated that a subsequent bill will be considered in early 2011 to make technical amendments to Dodd-Frank and to clarify, inter alia, an important exception for certain end-users from the requirement to centrally clear certain derivatives that are currently traded over-the-counter (“OTC”). [1]

The principal ways in which the drafters of Dodd-Frank intend for these objectives to be accomplished include:

Imposing substantial requirements on the most active OTC derivatives market participants, major swap participants (“MSPs”) and swap dealers (“SDs”), including reporting, capital and margin requirements;

Subjecting many derivatives that are currently traded OTC tocentral clearing and exchangetrading in regulated trading systems; and

Establishing more clearly the jurisdiction of the key regulators of derivatives, the Securities and Exchange Commission (the “SEC”) and the Commodity Futures Trading Commission (the “CFTC”), and repealing exemptions and exclusions that stood in the way of their regulation of the multi-trillion dollar OTC market. Title VII will mark the beginning of an intensive regulatory process to implement its provisions. While some of these provisions will become effective immediately, Congress has designed Dodd-Frank so that its parts will become effective in several stages. Congress has also delegated significant regulatory authority to regulatory agencies, with a mandate to adopt rules or conduct studies within prescribed times from enactment. Unless otherwise provided, Title VII becomes effective on a date that is the later of: (a) 360 days following the enactment of Dodd-Frank into law; or (b) to the extent that a provision thereof requires rulemaking, not less than 60 days after publication of the applicable final rule or regulation. A separate two-year phase-in period permits derivatives providers that now receive certain forms of federal assistance, including access to the discount window of the Federal Reserve, to divest themselves of certain derivative-related activities and investments.

For brevity, most of the following discussion is based primarily upon Title VII’s amendments to the Commodity Exchange Act (“CEA”), but there are parallel amendments to the securities laws in almost all cases.

II. Regulatory Agencies’ Authority

Title VII grants the CFTC extensive new authority over commodities derivatives markets as well as over swaps (“Swaps”), SDs and MSPs. Title VII also grants the SEC corresponding authority over security-based Swaps (“SBS”), security-based SDs (“SBSDs”) and major security-based swap participants (“MSBSPs”).2 Swaps and SBS are differentiated within Title VII by the asset class or underlier of the trade. Generally, SBS are defined as Swaps that are based on equities, bonds, or narrow-based security indices of these instruments,3 and are to be subject to the jurisdiction of the SEC. All other Swaps are to be regulated by the CFTC, with certain exceptions discussed below.

Both the CFTC and SEC are granted extensive authority throughout Title VII to define which products come within their exclusive jurisdiction, which products are to be centrally cleared and which market participants must comply with the mandates of Title VII.

SDs and MSPs are generally required to execute Swap transactions through an exchange facility and to clear these transactions through a derivatives clearing organization or agency (“DCO”). SDs and MSPs must comply with capital and margin requirements, as well as business conduct standards.

A. Demarcation of Jurisdiction of SEC and CFTC; “Mixed Swaps”; “Credit Default Swaps”; and “Identified Banking Products” The demarcation between the jurisdiction of the CFTC and the SEC was a point of some controversy in the legislative process for derivatives regulation, and some material jurisdictional ambiguities remain in Dodd-Frank.

Dodd-Frank generally grants the CFTC jurisdiction over Swaps (other than SBS) participants in the markets for Swaps (such as SDs and MSPs and their associated persons) and swap execution facilities. The CFTC also is granted jurisdiction over foreign exchange Swaps and foreign exchange forwards unless the Secretary of the Treasury makes a written determination that either or both instruments: (i) should not be regulated as Swaps; and (ii) are not structured to avoid the purpose of the legislation. (See discussion in Section III below.) Unlike security futures (which include futures on a single security or loan or a narrow-based index of securities), where the CFTC and the SEC have joint jurisdiction, the SEC will have sole jurisdiction over SBS and participants in SBS markets such as SBSDs and MSBSPs and their associated persons, as well as security-based swap execution facilities. It is not clear how the agencies are to exercise their jurisdiction over dealers and major participants that transact in both Swaps and SBS, but these firms are required to register with both agencies.

While the CFTC will generally have jurisdiction over Swaps and the SEC will generally have jurisdiction over SBS, Title VII addresses in a particular way the peculiarities of derivatives instruments that have features of both Swaps and SBS, referred to as “Mixed Swaps.” A Mixed Swap has some elements of a SBS, and also is based upon the value of one or more interest or other rates, currencies, commodities, instruments of indebtedness, indices, quantitative measures, other financial or economic interest or other property of any kind (except for a single security or a narrow-based security index), or the occurrence, non-occurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence (again, except for an event relating to a single security or a narrow-based security index). Mixed Swaps will be jointly regulated by the CFTC and the SEC, in consultation with the Federal Reserve Board. The definitions of Title VII suggest a few ways in which products may be regulated by the SEC, the CFTC, or both regulators:

An equity swap that is structured as an option to purchase emissions credits would come within the jurisdiction of the CFTC;

An equity swap that is an option to purchase shares of an equity security would come within the jurisdiction of the SEC;

An equity swap with payments that depend on the movement of an equity security and the price of a mineral such as gold would likely be deemed a “Mixed Swap,” in which case both the SEC and CFTC would share jurisdiction and both would jointly regulate that equity swap. While there are straightforward examples of how products would likely be regulated under Title VII, ambiguity remains, including in the division of jurisdiction over derivatives such as credit default Swaps (“CDS”) and equity Swaps (“ES”). If a CDS or ES is tied to the securities issued by a publicly-traded company, or of a narrow-based index of publicly-traded companies, that CDS or ES will be under SEC jurisdiction. Conversely, if a CDS or ES is tied to a broad-based index of publicly-traded companies, that CDS or ES will be under CFTC jurisdiction. Nonetheless, some CDS or ES may be subject to joint CFTC-SEC jurisdiction. For example, if a CDS or ES is based upon the debt of governmental entities, or is tied to mortgage-backed or asset-backed securities, it is not clear upon which side of the jurisdictional divide the instrument belongs. It is to be hoped that the agencies will clarify this issue so that market participants are not subject to duplicative or inconsistent regulation.

Certain “identified banking products” are excluded from the jurisdiction of the CFTC and the SEC (and the definitions of “security-based swap” and “security-based swap agreement”).4 However, an appropriate federal banking agency that has jurisdiction over a SD is authorized to make an exception to the exclusion for any particular identified banking product that it determines, in consultation with the CFTC and the SEC: (i) would meet the definition of Swap or SBS; and (ii) is known to the trade as a “swap” or “security-based swap” or otherwise has been structured to evade the CEA or the Securities Exchange Act of 1934, as amended (the “Exchange Act”). If the bank is not under the jurisdiction of an appropriate federal bank regulatory agency,5the “identified banking products” exclusion will not apply even if the above conditions are satisfied.

Read more here.

Senate oversight

See Derivatives - Senate oversight

House oversight

See House derivatives 2009.

US executive branch oversight and lawmaking

EU-US move closer to deal on derivatives regulation

US treasury secretary calls for EU-US co-operation while Michel Barnier welcomes US' ‘level of ambition'.

The European Commission has reached agreement in principle with the United States on regulation of the derivatives market.

Timothy Geithner, the US treasury secretary, has written to Michel Barnier, the European commissioner for the internal market, setting out a reform plan and calling for EU-US co-operation, which he said was essential to address systemic risks posed by derivatives that are traded between counterparties off exchanges, known as over-the-counter (OTC) derivatives.

A spokeswoman for Barnier said that the commissioner “very much welcomed the level of ambition” in Geithner's letter. She said Geithner's proposals were “completely in line” with a draft law that Barnier will present in June. Barnier's proposal would then have to be agreed by the EU's member states and the European Parliament. US priorities

Geithner's letter sets out four priorities for reform, namely:

  1. subjecting the market to substantial supervision and regulation (including conservative capital requirements);
  2. pushing all trading of standard (ie, commonly traded forms of) derivative contracts onto exchanges or other regulated trading platforms;
  3. obliging all traders of standard derivative contracts to use central counterparty clearing;
  4. giving regulators full authority to monitor transactions (including setting position limits).

Barack Obama, the US president, is currently pushing Congress to include regulation of derivatives trading in a financial reform bill that he wants adopted by the end of May. He said last week that he would veto any version of the bill that did not cover derivatives. Obama said that the US “can't afford another AIG” – a reference to the insurance company American International Group, which had to be bailed out by the US government at the height of the financial crisis because of overexposure to the derivatives market.

The tougher approach to derivatives has been incorporated into draft versions of a communiqué that G20 finance ministers are to adopt at a meeting in Washington, DC, tomorrow (23 April).

The Geithner letter goes further than reforms agreed at the last G20 summit, held in September in Pittsburgh, which agreed that standardised contracts should be cleared on exchanges “where appropriate”. It also goes farther than the European Commission's most recent policy paper on derivatives reform, from October 2009, which stopped short of proposing that all derivatives trading should be carried out on exchanges.

Co-ordinated regulation

The Geithner letter says that the EU and US should co-ordinate how they regulate non-financial firms that use the derivatives markets to hedge risk. Both the Commission and the US administration support a lighter regulatory regime for these companies, which only account for a small part of the over-the-counter market. Geithner has sent a similar letter to Jean-Claude Trichet, the president of the European Central Bank.

The G20 meeting is also expected to discuss international co-operation to wind up failing banks, and to address macroeconomic imbalances. The meeting will prepare the next summit of G20 leaders, which will take place in Toronto on 26-27 June.

OCC 4Q 2009 report on derivatives volumes at US banks

Executive Summary

  • The notional value of derivatives held by U.S. commercial banks increased $8.5 trillion in the fourth quarter, or 4.2%, to $212.8 trillion.
  • U.S. commercial banks reported trading revenues of $1.9 billion in the fourth quarter, down 66% from $5.7 billion in the third quarter. For the year, banks reported record trading revenues of $22.6 billion, compared to a loss of $836 million in 2008.
  • In the fourth quarter, net current credit exposure decreased 18%, or $86 billion, to $398 billion. Net current credit exposure dropped 50% during 2009.
  • Derivative contracts remain concentrated in interest rate products, which comprise 84% of total

derivative notional values. The notional value of credit derivative contracts, at $14 trillion, represents 7% of total notionals. Credit derivatives notional totals increased by 8% during the quarter.

The OCC’s quarterly report on trading revenues and bank derivatives activities is based on Call Report information provided by all insured U.S. commercial banks and trust companies, reports filed by U.S. financial holding companies, and other published data.

A total of 1,030 insured U.S. commercial banks reported derivatives activities at the end of the fourth quarter, a decrease of 35 banks from the prior quarter. Derivatives activity in the U.S. banking system continues to be dominated by a small group of large financial institutions. Five large commercial banks represent 97% of the total banking industry notional amounts and 88% of industry net current credit exposure.

While market or product concentrations are normally a concern for bank supervisors, there are three important mitigating factors with respect to derivatives activities.

  • First, because this report focuses on U.S. commercial banking companies, there are a number of other providers of derivatives products whose activity is not reflected in the data in this report.
  • Second, because the highly specialized business of structuring, trading, and managing derivatives transactions requires sophisticated tools and expertise, derivatives activity is concentrated in those banking companies that have the resources needed to be able to operate this business in a safe and sound manner.
  • Third, the OCC and other supervisors have examiners on-site at the largest banks to continuously evaluate the credit, market, operation, reputation, and compliance risks of derivatives activities.

In addition to the OCC’s on-site supervisory activities, the OCC continues to work with other financial supervisors and major market participants to address infrastructure issues in OTC derivatives, including development of objectives and milestones for stronger trade processing and improved market transparency across all OTC derivatives categories.

New OTC swaps rules must apply to all – U.S. regulatory official

Congress should not create blanket exemptions for end users from new rules designed to make trading of the over-the-counter derivatives more transparent, a commissioner on the top U.S. futures regulator said on Tuesday.

Michael Dunn said the Commodity Futures Trading Commission should be given the authority to exempt end users from requirements to trade and clear standardized derivatives on a case-by-case basis, but recommended against a broader exemption currently being considered by Senate committees.

“Allowing such a large class of transactions to be exempt from clearing would mean that dealers would have more risk on their books. If these dealers fail, this risk could affect the entire financial system,” Dunn said in remarks prepared for a National Futures Association regulatory seminar in Chicago.

Dunn’s comments are in line with CFTC Chairman Gary Gensler who has also argued against end user exemptions.

Senate banking and agriculture committees are currently working on bills that would give regulators oversight of the OTC derivatives market that the CFTC estimates is worth about $300 trillion in the United States alone.

The House of Representatives’ bill, passed in December, included clearing exemptions for end users. Senate committees working on legislation have also signaled they plan to include some exemptions, but details have not yet been released.

FDIC Chair on derivatives trading in insured depository institutions

"... I would like to share some concerns with respect to section 716 of S. 3217, which would require most derivatives activities to be conducted outside of banks and bank holding companies. If enacted, this provision would require that some $294 trillion in notional amount of derivatives be moved outside of banks or from bank holding companies that own insured depository institutions, presumably to nonbank financial firms such as hedge funds and futures commission merchants, or to foreign banking organizations beyond the reach of federal regulation. I would note that credit derivatives - the riskiest - held by banks and bank holding companies (when measured by notional amount) total $25.5 trillion, or slightly less than nine percent of the total derivatives held by these entities.

At the same time, it needs to be pointed out that the vast majority of banks that use OTC derivatives confine their activity to hedging interest rate risk with straightforward interest rate derivatives. Given the continuing uncertainty surrounding future movements in interest rates and the detrimental effects that these could have on unhedged banks, I encourage you to adopt an approach that would allow banks to easily hedge with OTC derivatives. Moreover, I believe that directing standardized OTC products toward exchanges or other central clearing facilities would accomplish the stabilization of the OTC market that we seek to enhance, and would still allow banks to continue the important market-making functions that they currently perform.

In addition, I urge you to carefully consider the underlying premise of this provision - that the best way to protect the deposit insurance fund is to push higher risk activities into the so-called shadow sector. To be sure, there are certain activities, such as speculative derivatives trading, that should have no place in banks or bank holding companies. We believe the Volcker rule addresses that issue and indeed would be happy to work with you on a total ban on speculative trading, at least in the CDS market. At the same time, other types of derivatives such as customized interest rate swaps and even some CDS do have legitimate and important functions as risk management tools, and insured banks play an essential role in providing market-making functions for these products."

Fannie and Freddie to centrally clear interest rate swaps

This is a big one: Fannie Mae and Freddie Mac will start using central counterparty clearing on their massive interest rate swaps portfolio, according to a Reuters report.

Why is it big? For one thing, the combined size of Fannie and Freddie’s interest rate portfolio is $3,000bn – or more than 20 per cent of the gross market value of the global interest rate swap market, according to BIS data as at June 2009.

Moreover, since Fannie and Freddie’s de facto nationalisation in 2008, they’ve gone from being ‘government sponsored’ entities to ‘the government’. As a result, as Reuters pointed out, their move to clearing “gave notice the government is putting its money where its mouth is”:

“You can’t kick and scream anymore because I am buy-side,” Martha Tirinnanzi, chairman of the Federal Housing Finance Agency’s clearinghouse working group, told reporters after a panel at the Futures Industry Association’s annual meeting here. “It will be a signal to the sell-side that this market has changed.”

As for just which of the competing clearing houses will have first dibs on that portfolio? Not yet, erm, clear:

The agencies have tested their portfolios with Nasdaq OMX Group Inc’s majority-owned clearinghouse, CME Group and LCH.Clearnet, she said, but they have not yet decided which to use

U.S. Treasury nominee: some swaps may stay off exchanges

"The nominee for the U.S. Treasury’s top domestic post on Tuesday said he believed certain derivatives contracts, such as dollar swaps, could be exempted from being traded on exchanges under Obama administration proposals to boost market transparency.

Jeffrey Goldstein, who was named in July 2009 to become Treasury undersecretary for domestic finance, told the Senate Finance Committee that the administration’s market reform proposals would prevent abuse and promote transparency, but there were certain cases where derivatives might be better off not traded on exchanges.

“I think that the exemptions would be in certain markets where you could adversely affect the trading of some important securities — including the dollar swaps, and other things,” Goldstein said, answering a question during a confirmation hearing. He added that he looked forward to examining the issue further with lawmakers.

Goldstein was asked about his views on currency swaps by Senator Maria Cantwell, a Democrat from Washington state, who criticized the use of cross-currency swaps employed by Goldman Sachs & Co on behalf of Greece as disguising the amount of Greece’s public debt.

“It’s all perfectly legal, but in my opinion its a scam, and we ought to have these regulated and on exchanges and have transparency and go through clearing houses,” Cantwell said.

Goldstein said he believed that the Treasury’s proposed improvements in trading practices for over-the-counter derivatives trade “is meant to restore confidence in the financial system and make sure that the we do not put taxpayers at risk in the way that occurred at the height of the financial crisis.”

Senators also questioned Goldstein about the work one of his previous employers — private equity firm Hellman & Friedman — did to set up tax-shelter “blocker” corporations in the Cayman Islands on be half of clients.

Goldstein said these entities were set up to aid tax-exempt organizations such as pension funds and universities to maintain their income as tax exempt.

NY Fed meets with dealers and buyside - January 14, 2010

Jan 14 (Reuters) - Big players in the $450 trillion derivatives markets agreed to increase transparency and expand the volume and type of contracts they route to central counterparties, the New York Federal Reserve said on Thursday.

Derivatives, which are based on underlying assets including bonds and commodities or can be tied to currency and interest rate moves, were blamed for exacerbating the credit crisis and contributed to a run on assets that helped fell banks including Lehman Brothers.

The latest effort is a bid by the industry to reduce risks in the privately traded markets. The industry has been under heavy pressure to become safer after the government bailed out American International Group (AIG.N) because the insurer had a massive exposure to risky assets using credit default swaps, which are used to insure against a debt default.

Large market participants -- including banks like JPMorgan Chase & Co (JPM.N), investment companies such as Pacific Investment Management Co and industry groups -- met with regulators on Thursday at a meeting hosted by the New York Fed.

They agreed to provide regulators with additional information on trades in an effort to enhance efforts to move more of the market to central counterparties.

"The industry must undertake a major transformation to bring significantly greater levels of transparency to these markets. Increasing the amount and quality of market information available to participants, regulators and the public is critical to the work of shoring up the stability and efficiency of the financial system," William Dudley, president of the New York Fed, said in the release.

Greater use of central counterparties, which stand between trading partners and guarantee trades, is expected to help reduce the risks of a bank run, which would improve the stability of the financial sector.

Banks and fund managers also agreed to expand the volume and range of contracts that are currently deemed eligible for central clearing.

Debate over what contracts are eligible for central clearing, however, remains lively as banks and clearinghouses fear that taking on the risks of hard-to-value contracts will only succeed in shifting risks from banks to the central counterparties.

Details over what trading information will be provided to regulators, and how much may be made available to the public, also remain unresolved, said a person with knowledge of Thursday's meeting.

Large derivatives participants will detail new commitments in a letter due to be sent to regulators by March 1.

Derivatives dealers and users also reaffirmed commitments to formalize best practices, including margining requirements, for derivatives that are not centrally cleared.

IntercontinentalExchange Inc (ICE.N) and CME Group (CME.O) are the only clearinghouses in the U.S. that have begun clearing CDSs.

Banks in September agreed to submit 95 percent of eligible credit derivatives, and 90 percent of eligible interest rate derivatives, to central counterparties.

Chair Gensler on regulating OTC derivatives Jan, '10

"... Financial intermediation – that is, the pricing and allocation of capital and risk – is critical to every part of our economy. This intermediation can either be done through financial institutions – typically banks – or through the benefit of a centralized marketplace. The more standard the products are, the more able they are to trade in a marketplace. For example, investors buy and sell stocks in a marketplace.

Over-the-counter derivative contracts have become much more standardized. In fact, by some estimates, between two thirds and three quarters of interest rate derivatives and credit default swaps could be standardized. In energy and other commodity markets, some estimates are that approximately half could be standardized. With the standardization and computerization of derivative transactions, the time has come to bring the benefits of a central marketplace that lowers risk and allows market participants to see how contracts are priced.

Some opponents of reform argue that derivatives were not at the center of the crisis and should thus not be regulated. I believe, however, that over-the-counter derivatives were at the heart of the crisis. We have all witnessed firsthand the effects that unregulated derivatives had across the entire economy. Everybody in this room put money into a single company that was so interconnected with other financial institutions that its failure threatened the entire system. $180 billion of taxpayer money went into AIG. That’s about $600 from each person in this room.

But the lessons from the crisis go far beyond AIG. While derivatives are intended to help transfer and lower risk in the economy, the financial crisis demonstrated that they also can concentrate risk among a few big banks. All of the major derivatives dealers – all recipients of taxpayer TARP money – internalize their derivatives trading, retaining significant risk. Those banks have become increasingly interconnected with other institutions. The market also has become highly concentrated, with five or six big institutions on Wall Street and maybe 15 around the globe dealing in derivative products. Risk becomes like a spider’s web that spreads throughout the economy. Data collected by the Bank of International Settlements indicates that though approximately 40 percent of over-the-counter derivatives are transacted between two reporting derivatives dealers, the remaining are between those dealers and their financial and corporate customers. When the financial system failed, those risks were externalized to the public in the form of a taxpayer-funded bailout.

I believe comprehensive reform must include three key components. First, we must explicitly regulate the derivative dealers. Leading up to the financial crisis, it was assumed that the banks that deal in derivatives were already regulated, and thus did not need to be explicitly regulated for their derivative transactions. The financial crisis demonstrated that this was a flawed assumption. While banks and securities firms were regulated by their prudential regulators, their affiliates that traded derivatives were often left ineffectively regulated – that was the case for Lehman Brothers and AIG. Even though derivatives were traded inside a regulated bank, the banks were not regulated explicitly for their derivatives trading.

Second, regulatory reform must bring sunshine to the opaque over-the-counter derivatives markets. Over-the-counter derivatives are traded out of sight of federal regulators and out of sight of market participants. This was at the core of the financial crisis. We all recall in the midst of the crisis the inability to price particular mortgage derivatives. The public learned a new term – “toxic assets” – assets held by banks that were too difficult to price. Bringing transparency to the over-the-counter derivatives markets shifts the information advantage from a small group of derivative dealers on Wall Street to the broader market. This not only benefits end-users, but increases competition in the markets by lowering the barriers to entry for additional market makers and liquidity providers. A greater number of market makers also lowers risk to the system and provides greater liquidity.

We would not tolerate if other markets operated similarly to over-the-counter derivatives, where the dealer is the only one with the information. It would be like buying an apple from the supermarket when the price of the apple is kept private. How would you know if you got a fair price if you didn’t know how much the last person paid for the same apple? Further, it would be like putting 100 shares of a stock into your 401k with no knowledge of where the market prices the stocks. It is essential that we bring the benefits of a transparent marketplace to the opaque over-the-counter derivatives markets.

Third, to reduce interconnectedness in the system, standard over-the-counter derivative transactions should be moved into well-regulated clearinghouses. In the over-the-counter derivatives markets, trades are left on the books of the dealers after they are transacted. An interest rate derivative, for example, could stay on a dealer’s books for many years. As markets move, the value of those transactions change, but interconnectedness remains. The crisis showed how this interconnectedness concentrates and heightens risk to the American public.

Clearinghouses act as a middleman between two parties in an over-the-counter derivative transaction after the trade is arranged. They require derivatives dealers to post collateral so that if one party fails, its failure does not harm its counterparties and reverberate throughout the financial system. It is essential that we reduce this risk in the system. Otherwise, we could see a repeat of the financial crisis as the risk is externalized and the taxpayers are left on the hook.

I understand that improving transparency and lowering risk would mean big changes for Wall Street. We would move standardized over-the-counter derivatives out of a dealer-dominated market and into a centralized marketplace. I worked on Wall Street for 18 years with talented individuals from around the world who operated at the highest levels of professionalism. Wall Street’s interests are not always the same as the American public’s interests. In maximizing their profits, the banks are fulfilling their fiduciary duty to their shareholders, but they do not owe a similar duty to the taxpayers. We watched in 2008 when the financial system failed. It is time to change the way these markets function and the way they are regulated to benefit the public and to protect the American taxpayers.

Chair Gensler's on regulating OTC derivatives - Sept, '09

"...As we move forward with regulatory reform, we do so with the full knowledge of the failures of our financial regulatory system. The last decade, and particularly the last 24 months, has taught us much about the new realities of our financial markets. We have learned the limits of foresight and the need for candor about the risks we face. We have learned that transparency and accountability are essential. Only through strong, intelligent regulation can we fully protect the American people and keep our economy strong.

We have all felt the effects of the failures of our regulatory system. Every single person in this room had to put money into a company that most Americans had never even heard of. $180 billion of the tax dollars that you and I paid went into AIG to keep its collapse from further harming the economy. We must ensure that this never happens again. We cannot afford any more billion-dollar bailouts.

The need for reform of our financial system today has many similarities to the situation facing the country in the 1930s. In 1934, President Roosevelt boldly proposed to the Congress “the enactment of legislation providing for the regulation by the Federal Government of the operation of exchanges dealing in securities and commodities for the protection of investors, for the safeguarding of values, and so far as it may be possible, for the elimination of unnecessary, unwise, and destructive speculation.” The Congress swiftly responded to the clear need for reform by enacting the Securities Act of 1933, the Securities Exchange Act of 1934 and the Commodity Exchange Act of 1936.

It is clear that we need the same type of comprehensive regulatory reform today. Last month, the Obama Administration, through the Treasury Department, took a crucial step of submitting legislation to Congress to apply regulation to the over-the-counter derivatives markets. The proposal is a very important step toward comprehensive regulation of both derivative dealers and the markets on which derivatives are traded. This is vital for the future of our economy and the welfare of the American people.

The Administration’s proposal will lower risk by requiring capital and margin on dealers and mandatory clearing of all standardized products. It will enhance market integrity by protecting against fraud, manipulation and other abuses and establishing new authorities to set aggregate position limits. It will promote transparency and market efficiency by requiring record-keeping and reporting for all derivatives and requiring that standardized derivatives be traded on transparent exchanges or other regulated trading platforms. As we move forward, working with Congress, to comprehensively regulate the OTC markets, we should ensure that the law covers the entire marketplace without exception.

I believe that comprehensive regulation of the OTC derivatives markets will require two complementary regimes – one for regulation of the dealers, or the actors, and one for regulation of the market, or stage.

For dealers, we should set capital standards and margin requirements to help lower risk. We should also set business conduct standards to guard against fraud, manipulation and other market abuses. We should mandate recordkeeping and reporting to promote transparency. This will cover all OTC derivatives, both standardized and customized.

This must cover all of the different products, including interest rate swaps, currency swaps, commodity swaps, equity swaps and credit default swaps, as well as the derivative products that we have not yet thought of.

We should also regulate the market functions. We should require that all derivatives that can be moved into central clearing have a requirement to be cleared through regulated central clearing houses to further lower risk. To further promote transparency, we should require that standardized OTC derivatives come onto regulated exchanges regulated transparent trading systems.

Requiring clearing and trading on exchanges or regulated transparent electronic trading systems will promote transparency and market integrity and lower systemic risks. Through clearing, firms, rather than having exposures to each other, would have a clearinghouse that provides for broader risk-taking and that subjects participants to the daily discipline of mark-to-market valuations and the daily posting of collateral.

Tens of thousands of end users will benefit from the transparency brought by moving standardized swaps onto exchanges or regulated trading platforms. This transparency should give end users better pricing on both standard products and even on customized products, as customized products would be priced in relation to the standard products traded on exchanges. While some have raised a concern that this might limit commercial risk management or even innovation in the markets, I believe that this will enhance the ability of end users to effectively manage their risk.

To fully regulate OTC derivatives, we must work with Congress to enact both of these complementary regimes. Regulating both the traders and the trades will ensure that we cover both the actors and the actions that may create significant risks.

The President's proposed legislation for derivatives regulation

Source: Regulation of OTC Derivative Markets

  • Require Central Clearing and Trading of Standardized OTC Derivatives
  • Move More OTC Derivatives into Central Clearing and Exchange Trading
  • Require Transparency for All OTC Derivative Markets
  • Extend the Scope of Regulation to Cover all OTC Derivative Dealers and other Major Participants in the OTC Derivative Markets
  • Bring Robust and Comprehensive Prudential Regulation to all OTC Derivative Dealers and other Major Participants in the OTC Derivative Markets
  • Preventing Market Manipulation, Fraud, and other Market Abuses
  • Protecting Unsophisticated Investors

Department of Justice investigation of Markit

Source: Credit Swaps Probed for Antitrust Over Trading, Clearing, Data, July 16, (Bloomberg)

"The Justice Department said it’s conducting an antitrust probe of the $28 trillion credit-default swap market that may determine if banks were anticompetitive in their use of clearinghouses to back trades.

“The antitrust division is investigating the possibility of anticompetitive practices in the credit derivatives clearing, trading and information services industries,” Laura Sweeney, a Justice Department spokeswoman in Washington, said in an e-mail yesterday. She declined to elaborate.

The division sent civil investigative notices this month to banks that own London-based Markit Group Ltd. to find out if they have unfair access to price information, according to three people familiar with the matter. Congress plans to increase regulation of the $592 trillion over-the-counter derivatives market, which includes credit-default swaps blamed for helping worsen the biggest financial calamity since the Great Depression.

Markit provides derivative and bond data to more than 1,500 customers. It owns the most actively-traded credit swap indexes and pricing services in the market, which represents $28 trillion in underlying securities, according to the New York- based Depository Trust & Clearing Corp.

Clearinghouses, capitalized by members, insure both sides against default by the other.

Intercontinental Exchange Inc.’s ICE Trust clearinghouse is the only credit swap trade guarantor, having backed more than $1.3 trillion of the contracts since March. ICE Trust is supported by Wall Street’s largest banks, which will split profit from the venture beginning next year. CME Group Inc.’s CMDX clearing system, in partnership with Chicago-based hedge fund Citadel Investment Group LLC, hasn’t processed any trades.

The Justice Department might “be exploring big banks’ failure to deal with competing clearinghouse ventures like the CME’s,” said Craig Pirrong, a finance professor at the University of Houston.

Kelly Loeffler, a spokeswoman for Atlanta-based Intercontinental, and Mary Haffenberg, a spokeswoman for Chicago’s CME Group, declined to comment.

New York-based JPMorgan Chase & Co. is Markit’s largest shareholder, followed by Bank of America Corp. of Charlotte, North Carolina, Edinburgh-based Royal Bank of Scotland Group Plc and New York-based Goldman Sachs Group Inc., according to filings at U.K. Companies House. All four, as well as Morgan Stanley of New York, Frankfurt-based Deutsche Bank AG, Zurich- based UBS AG and others, are members of ICE Trust that will receive profits beginning 2010."

Fed's efforts to restrict oversight in '99 and '05

"... Testimony of Patrick M. Parkinson, Associate Director, Division of Research and Statistics On modernization of the Commodity Exchange Act, Before the Subcommittee on Risk Management, Research, and Specialty Crops, Committee on Agriculture, U.S. House of Representatives May 18, 1999...

The [Federal Reserve] Board believes that the application of the CEA to the trading of financial derivatives by professional counterparties is unnecessary. Prices of financial derivatives are not susceptible to, that is, easily influenced by, manipulation. Some financial derivatives, for example, Eurodollar futures or interest rate swaps, are virtually impossible to manipulate, because they are settled in cash, and the cash settlement is based on a rate or price in a highly liquid market with a very large or virtually unlimited deliverable supply.

For other financial derivatives--for example, futures contracts for government securities--manipulation of prices is possible, but it is by no means easy. Large inventories of the instruments are immediately available to be offered in markets if traders endeavor to create an artificial shortage. Furthermore, the issuers of the instruments can add to the supply if circumstances warrant. This contrasts sharply with supplies of agricultural commodities, for which supply is limited to a particular growing season and finite carryover.

In addition, professional counterparties simply do not require the kind of investor protections that the CEA provides. Such counterparties typically are quite adept at managing credit risks and are more likely to base their investment decisions on independent judgment. And, if they believe they have been defrauded, they are quite capable of seeking restitution through the legal system. Nor is there any obvious public policy reason to foster direct retail participation in financial derivatives markets...

... Testimony of Patrick Parkinson, Deputy Director, Division of Research and Statistics, Commodity Futures Modernization Act of 2000, Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, September 8, 2005…

The Federal Reserve Board believes that the CFMA has unquestionably been a successful piece of legislation. Most important, as recommended by the President's Working Group on Financial Markets in its 1999 report, it excluded transactions between institutions and other eligible counterparties in over-the-counter financial derivatives and foreign currency from regulation under the Commodity Exchange Act (CEA).1

As the Working Group argued, regulation of such transactions under the CEA was unnecessary to achieve the act's principal objectives of deterring market manipulation and protecting investors. Such transactions are not readily susceptible to manipulation and eligible counterparties can and should be expected to protect themselves against fraud and counterparty credit losses. Exclusion of these transactions resolved long-standing concerns that a court might find that the CEA applied to these transactions, thereby making them legally unenforceable.

At the same time, the CFMA modernized the regulation of U.S. futures exchanges, replacing a one-size-fits-all approach to regulation with an approach that recognizes that the regulatory regime necessary and appropriate to achieve the objectives of the CEA depends on the nature of the underlying assets traded and the capabilities of market participants. Together, these provisions of the CFMA have made our financial system and our economy more flexible and resilient by facilitating the transfer and dispersion of risk. Consequently, the Board believes that major amendments to the regulatory framework established by the CFMA are unnecessary and unwise.

Fed's endorsement of oversight in '08

Patrick M. Parkinson, Deputy Director, Division of Research and Statistics, Credit derivatives Before the Committee on Agriculture, U.S. House of Representatives, November 20, 2008…

As noted in my earlier statement, supervisors have worked with market participants since 2005 to strengthen the infrastructure of credit derivatives markets through such steps as greater use of electronic confirmation platforms, adoption of a protocol that requires participants to request counterparty consent before assigning trades to a third party, and creation of a contract repository, which maintains an electronic record of CDS trades. Looking forward, the most important potential change in the infrastructure for credit derivatives is the creation of one or more central counterparties (CCPs) for CDS. The Federal Reserve supports CCP clearing of CDS because, if properly designed and managed, CCPs can reduce risks to market participants and to the financial system. In addition to clearing of CDS through CCPs, the Federal Reserve believes that exchange trading of sufficiently standardized contracts by banks and other market participants can increase market liquidity and transparency and thus should be encouraged.

Policy discussions of potential regulatory changes for CDS have focused on preventing market manipulation, improving transparency, and mitigating systemic risk. Manipulation concerns can be addressed by clarifying the Securities and Exchange Commission's (SEC) authority with respect to CDS. Data from a contract repository provide a means for enhancing transparency, a topic I will discuss in greater depth later. To better contain systemic risk, prudential supervisors already have begun to address the weaknesses of major market participants in measuring and managing their counterparty credit risks. This step is fundamental to containing systemic risk because it helps limit the potential for any single large market participant to be the catalyst for transmission of such risk.

Market reaction to proposals

Global derivatives statistics

US derivatives concentration

  • The notional value of derivatives held by U.S. commercial banks increased $3.6 trillion in the first

quarter, or 1.7%, to $216.5 trillion.

  • U.S. commercial banks reported trading revenues of $8.3 billion in the first quarter, 15% lower than $9.8 billion of revenue in the first quarter of 2009.
  • Credit exposure from derivatives continues to decline. Net current credit exposure decreased 10%, or $40 billion, to $359 billion. Net current credit exposure dropped 50% during 2009.
  • Derivative contracts remain concentrated in interest rate products, which comprise 84% of total

derivative notional values. The notional value of credit derivative contracts, at $14.4 trillion, represents 7% of total notionals. Credit derivatives increased by 2.3% during the quarter.

The notional value of derivatives held by U.S. commercial banks increased $8.5 trillion in the fourth quarter, or 4.2%, to $212.8 trillion.

  • U.S. commercial banks reported trading revenues of $1.9 billion in the fourth quarter, down 66% from $5.7 billion in the third quarter. For the year, banks reported record trading revenues of $22.6 billion, compared to a loss of $836 million in 2008.
  • In the fourth quarter, net current credit exposure decreased 18%, or $86 billion, to $398 billion. Net current credit exposure dropped 50% during 2009.
  • Derivative contracts remain concentrated in interest rate products, which comprise 84% of total

derivative notional values. The notional value of credit derivative contracts, at $14 trillion, represents 7% of total notionals. Credit derivatives notional totals increased by 8% during the quarter.

U.S. commercial banks earned $5.2 billion trading derivatives in the second quarter, as the level of risk eased in the global market for the complex financial instruments, according to a government report released Friday.

A total of 1,110 U.S. commercial banks reported trading or holding derivatives at the end of the second quarter, up 47 from the first quarter, according to the Office of the Comptroller of the Currency, a Treasury Department agency. Still, five big banks – J.P. Morgan Chase & Co., Goldman Sachs Group Inc., Bank of America Corp., Citigroup Inc. and Wells Fargo & Co. -- account for 97% of the total derivatives reported to be held by U.S. commercial banks.

The $5.2 billion in banks' trading revenues in the April-June period was down from a record $9.8 billion in the first quarter, but a decline had been expected and was at least partly due to seasonal changes, the agency said. The second-quarter revenues were the sixth-largest since the agency began keeping records in 1996. Banks earned a total $1.6 billion in trading revenues in the second quarter of 2008.

At the same time, the primary measure of credit risk in derivatives trading -- called net current credit exposure -- fell $140 billion, or 20%, in the second quarter to $555 billion.

The risk measure has decreased significantly over the first half of this year, "although by any standard these (credit) exposures remain very high," said Kathryn Dick, the deputy comptroller for credit and market risk, in a statement.

The narrowing of the gap between the rates at which banks are willing to lend and what borrowers are willing to pay indicates that "the [credit] market feels better about the quality" of the banks that trade in derivatives, Ms. Dick said in a conference call with reporters.

Derivatives, traded in an unregulated $600 trillion market, were partly blamed for the financial crisis that ignited a year ago. The value of derivatives hinges on an underlying investment or commodity -- such as currency rates, oil futures or interest rates. The derivative is designed to reduce the risk of loss from the underlying asset. Derivatives trading is dominated by about 20 big banks world-wide.

Credit default swaps, a form of insurance against loan defaults, account for an estimated $60 trillion of the over-the-counter derivatives market. The collapse of the swaps brought the downfall of Wall Street banking house Lehman Brothers Holdings Inc. about a year ago and nearly toppled American International Group Inc., prompting the government to support the insurance conglomerate with more than $180 billion in aid.

Contracts on interest rates and foreign exchange rates also figure prominently in the derivatives market.

Congress is weighing legislation to impose broad new oversight on derivatives. The Obama administration's proposal, part of its plan for overhauling U.S. financial rules, would subject the banks that trade derivatives to requirements for holding capital reserves against risk and other rules. A new network of clearinghouses would be established to provide transparency for derivatives trades.

Last year as the credit crisis raged, U.S. commercial banks recorded their first industrywide loss on derivatives trading. The $836 million loss compared with trading revenue of $5.49 billion in 2007, according to the comptroller's office.

The agency's second-quarter report found that the total value of derivatives held at U.S. commercial banks rose to $203.5 trillion, up by $1.5 trillion, or about 1%, from the first quarter.

Members of Congress probing threats to the global financial system — especially the threat of concentration of risk — will have a lot to ponder in newly mandated disclosures highlighted by a Fitch Ratings report issued last week. While derivatives use among U.S. companies is widespread, an "overwhelming majority of the exposure is concentrated among financial institutions," according to the rating agency's review of first-quarter financials.

Concentrated, in fact, among a mere handful of financial-services giants. About 80% of the derivative assets and liabilities carried on the balance sheets of 100 companies reviewed by Fitch were held by five banks: JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley. Those five banks also account for more than 96% of the companies' exposure to credit derivatives.

About 52% of the companies reviewed disclosed there were credit-risk-related contingent features in their derivative positions. Such features require a company to post collateral or settle outstanding derivative liabilities if there's a downgrade of the company's credit rating.

The Fitch analysts also found that just 22 companies disclosed the use of equity derivatives. Just six nonfinancial firms — IBM, General Motors, Verizon, Comcast, Textron, and PG&E — reported exposure to share-based derivatives.

For the report, the rating agency reviewed first-quarter 2009 filings of the companies, which come from a range of industries and represent almost $6.4 trillion in aggregate outstanding debt. The companies also recorded a total notional amount of derivative positions of more than $296 trillion.

Unlike the financial firms, which both use derivatives and issue them for profit, nonfinancial companies seem mostly to use derivatives just to hedge specific risks, according to Fitch. While "derivatives trading by utilities and energy companies appear to be very limited," for instance, "most of the companies reviewed in both industries report the use of derivatives for hedging commodity risks," the report found.

The first-quarter 2009 financial reports marked the first time comprehensive derivatives disclosure was mandated for all U.S. companies. "The need for better disclosure on derivatives has been obvious since the implementation of Statement of Financial Accounting Standards 133, Accounting for Derivative Instruments and Hedging Activities," according to the Fitch report. But comprehensive disclosure of derivatives wasn't part of U.S. generally accepted accounting principles for most companies until March, when the Financial Accounting Standards Board implemented SFAS 161, Disclosures about Derivative Instruments and Hedging Activities.

The latter standard is an attempt to simplify hedge accounting, perhaps the most notorious example of the complexity of U.S. financial reporting. More than 800 pages of rulemaking and guidance were needed to make sense of SFAS 133.

For its part, SFAS requires companies to improve their disclosures about how they account for and use derivatives, and how derivatives affect their balance sheets, income statements, and cash-flow statement.

"The new derivative disclosures are a welcome addition for analysts and investors, and they bring much-needed transparency to financial reporting," says Olu Sonola, a Fitch Ratings director. "The disclosures reveal plenty, but careful analysis and additional scrutiny must be applied."

In particular, users of financial statements need added information about the sensitivity of companies' derivative valuations to major assumptions, according to the ratings agency. Since risk analysts often base their derivative valuations on quantitative models, changes in significant valuation assumptions are particularly important, says Fitch.

The firm's analysts reported that perhaps "the most surprising information coming from our review of energy companies" was that Exxon Mobil — the biggest U.S. energy company — had no derivative exposure at the end of the first quarter. Instead, the company appears to rely on what's called natural hedges — countervailing trends within the corporation itself — to manage potential risks. The report cited Exxon's 2008 10-K:

"The corporation's size, strong capital structure, geographic diversity and the complementary nature of the upstream, downstream and chemical businesses reduce the corporation's enterprise-wide risk from changes in interest rates, currency rates and commodity prices. As a result, the corporation makes limited use of derivative instruments to mitigate the impact of such changes. The corporation does not engage in speculative derivative activities or derivative trading activities nor does it use derivatives with leveraged features."

Arguments for derivatives regulation

Credit derivatives such as credit default swaps (CDS) can be thought of as insurance policies that protect a lender from the risk of default by the borrower. Party A pays a premium to Party B, who agrees to pay Party A in the event Party C defaults on its obligations, such as bonds. CDS can be used to hedge or can be used speculatively. Derivatives usage grew dramatically in the years preceding the crisis. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. Total over-the-counter (OTC) derivative notional value rose to $683 trillion by June 2008.[1]

Warren Buffett famously referred to derivatives as "financial weapons of mass destruction" in early 2003.The Economist-"Derivatives-A Nuclear Winter?"[2]

Former President Bill Clinton and former Federal Reserve Chairman Alan Greenspan indicated they did not properly regulate derivatives, including credit default swaps (CDS). Clinton-Derivatives, Greenspan says was "partially" wrong on CDS regulation, Gensler Says Clinton Team Should Have Done More on Derivatives

Economist Joseph Stiglitz summarized how CDS contributed to the systemic meltdown: "With this complicated intertwining of bets of great magnitude, no one could be sure of the financial position of anyone else-or even of one's own position. Not surprisingly, the credit markets froze." [3]

NY Insurance Superintendent Eric Dinallo argued in April 2009 for the regulation of CDS and capital requirements sufficient to support financial commitments made by institutions. "Credit default swaps are the rocket fuel that turned the subprime mortgage fire into a conflagration. They were the major cause of AIG’s – and by extension the banks’ – problems...In sum, if you offer a guarantee – no matter whether you call it a banking deposit, an insurance policy, or a bet – regulation should ensure you have the capital to deliver." He also wrote that banks bought CDS to enable them to reduce the amount of capital they were required to hold against investments, thereby avoiding capital regulations.[4]


The recent credit crisis has highlighted the lack of regulation for credit default swaps that has both magnified and contributed to market failure that began in the latter half of 2008. Securities regulation covers most types of investment contracts, but currently does not include non-securities based derivative contracts such as credit default swaps. The unique aspect of credit default swaps is that unlike other risk shifting contracts such as insurance, they are not regulated. The regulatory framework lacks a consistent approach in dealing with risk shifting and hedging devices. The degree of regulation is based on the form of the instrument rather than on the substance of the risk shifting transactions. This essay is an abridged and updated version of a 2005 article that questioned the wisdom of deregulation in the derivatives markets that has taken place since the early 1990s.

Arguments against regulating credit derivatives

Credit derivatives provide market signals regarding the risk of particular investments. For example, the cost of providing CDS protection for particular bonds is a signal regarding the risk of those bonds.

CDS also allow particular credit risks to be hedged, as an entity can purchase protection from many sources of credit risk, much like an insurance policy.

While total notional value related to CDS is enormous (estimated between $25–$50 trillion), the true exposure related to that notional value is approximately $2.5-$3.0 trillion.

This amount would only be lost if the underlying assets lost their entire value (i.e., akin to all the cars insured by car insurance companies being totaled simultaneously; CDS insure bonds instead of cars), which is outside any reasonable scenario.

Since many of these CDS provide protection against defaults of bonds in quality companies, true risk of loss related to CDS is considerably less. AEI - Wallison - Credit Default Swaps

Global oversight

BIS triennial central bank survey of FX and derivatives

In April this year, 53 central banks and monetary authorities participated in the eighth Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity ("the triennial survey"). The objective of the survey is to provide the most comprehensive and internationally consistent information on the size and structure of global foreign exchange markets, allowing policymakers and market participants to better monitor patterns of activity in the global financial system. 1 Coordinated by the BIS, participating institutions collect data from some 1,300 reporting dealers on turnover in foreign exchange instruments and OTC interest rate derivatives. The triennial survey has been conducted every three years since April 1989, and has been modified since April 1995 to include OTC interest rate derivatives.

Previous triennial surveys have used the expression "traditional foreign exchange markets" to refer to spot transactions, outright forwards and foreign exchange swaps. This expression excludes currency swaps and currency options, which are under OTC instruments. Beginning with the 2010 survey, the expression "global foreign exchange markets" will include all five foreign exchange instruments. Turnover on global foreign exchange markets and in interest rate derivatives is analysed in Tables 1 to 5 and in Tables 6 to 9, respectively.

The headline figures from the April 2010 survey are the following:

1. Turnover on the Global foreign exchange market

Global foreign exchange market turnover was 20% higher in April 2010 than in April 2007, with average daily turnover of $4.0 trillion compared to $3.3 trillion.

The increase was driven by the 48% growth in turnover of spot transactions, which represent 37% of foreign exchange market turnover. Spot turnover rose to $1.5 trillion in April 2010 from $1.0 trillion in April 2007.

The increase in turnover of other foreign exchange instruments was more modest at 7%, with average daily turnover of $2.5 trillion in April 2010. Turnover in outright forwards and currency swaps grew strongly. Turnover in foreign exchange swaps was flat relative to the previous survey, while trading in currency options decreased.

As regards counterparties, the higher global foreign exchange market turnover is associated with the increased trading activity of "other financial institutions" - a category that includes non-reporting banks, hedge funds, pension funds, mutual funds, insurance companies and central banks, among others. Turnover by this category grew by 42%, increasing to $1.9 trillion in April 2010 from $1.3 trillion in April 2007. For the first time, activity of reporting dealers with other financial institutions surpassed inter-dealer transactions (ie transactions between reporting dealers).

Foreign exchange market activity became more global, with cross-border transactions representing 65% of trading activity in April 2010, while local transactions account for 35%.

The percentage share of the US dollar has continued its slow decline witnessed since the April 2001 survey, while the euro and the Japanese yen gained relative to April 2007. Among the 10 most actively traded currencies, the Australian and Canadian dollars both increased market share, while the pound sterling and the Swiss franc lost ground. The market share of emerging market currencies increased, with the biggest gains for the Turkish lira and the Korean won.

The relative ranking of foreign exchange trading centres has changed slightly from the previous survey. Banks located in the United Kingdom accounted for 36.7%, against 34.6% in 2007, of all foreign exchange market turnover, followed by the United States (18%), Japan (6%), Singapore (5%), Switzerland (5%), Hong Kong SAR (5%) and Australia (4%). 2. Turnover in OTC interest rate derivatives

Activity in OTC interest rate derivatives grew by 24%, with average daily turnover of $2.1 trillion in April 2010. Almost all of the increase relative to the last survey was due to the growth of forward rate agreements (FRAs), which increased by 132% to reach $601 billion. More detailed results on developments in the foreign exchange and OTC derivatives markets and comprehensive explanatory notes describing the coverage of and terms used to present the statistics are included in the separate statistical release of the data. Explanatory notes follow statistical tables.

The BIS plans to publish, in November 2010, the detailed results of the activity in April 2010 and of the positions at end June 2010 on FX instruments. A specific press release will also be published in November on the global OTC positions at end June 2010. In addition, special features will be devoted to the Survey in the December 2010 BIS Quarterly Review.

IOSCO on derivatives regulation

CESR on oversight of derivatives

EU backs tougher US line on derivatives

The US administration’s tougher talk on clamping down on the over-the-counter (OTC) derivatives markets was welcomed on Monday by the European Union’s top financial services regulator.

Michel Barnier, financial services commissioner, said issues raised by the Goldman Sachs mis-selling allegations “strengthened his belief” that Europe needed to act and that “years of murkiness and opacity” in the derivatives market must be ended.

His reaction was designed as a show of solidarity with the White House push to ensure that Wall Street’s control over the lucrative OTC derivatives trading business could never again lead to – or worsen – a financial crisis.

Both the US and Europe have made clear their determination to stick to commitments made last year by the G20 group of leading economies on the need to reform the vast OTC derivatives markets.

Both sides are moving broadly in the same direction when it comes to shifting OTC derivatives away from the Wall Street dealers, who currently dominate trading in such instruments, to formal exchanges and other electronic platforms to make prices more publicly available.

They also want OTC derivatives processed via clearing houses to safeguard against the catastrophic fallout in case of a default – such as the Lehman Brothers collapse in September 2008. But with the issue of derivatives becoming politically charged in an election year for US President Barack Obama’s Democratic party, moving in step with other countries has become harder, say some in the derivatives industry.

On Monday, Richard Raeburn, chairman of the European Association of Corporate Treasurers, questioned “whether the US can really be aligned with the [less populist] EU approach”.

In a letter to Jean-Claude Trichet, European Central Bank president, Tim Geithner, the US Treasury secretary, reiterated a determination to subject all OTC dealers to “substantial” regulation; that all “standard derivatives contracts must be traded transparently on regulated exchanges or other regulated and transparent trading platforms”.

Chinese derivatives rules hit global banks

"Many of the world’s biggest banks are in effect locked out of China’s small but fast-growing derivatives markets after refusing to sign new trading agreements with the Chinese institutions that control the market.

The stand-off has caused foreign banks’ share of local derivatives trading to plummet, undermining their ambitions to expand their Chinese interest rate, foreign exchange and credit derivatives operations.

China’s four largest state-owned banks control the vast majority of the onshore derivatives markets.

They are requiring locally incorporated foreign banks to secure contractual guarantees from their global headquarters to guard against trading defaults before dealing with them in the derivatives market.

The request is unprecedented and “makes a mockery of the requirement that foreign banks incorporated locally in the first place”, according to one senior China-based western banker who asked not to be named because of the sensitivity of the subject.

The demands are the latest example of how mainland officials are taking a more assertive stance towards their western counterparts after the financial crisis toppled several European and US institutions.

“They’ve asked for guarantees that are very difficult to give,” said Keith Noyes, Asia head of the International Swaps and Derivatives Association. “You have a stalemate now.”

Market participants said that, largely as a result of the stand-off, the volume of trade in renminbi/foreign exchange swaps has tumbled in recent months from the $3.4bn average per day that it was trading as recently as July.

Until then, trading volumes in foreign exchange swaps had grown rapidly after China removed its long-standing currency peg to the dollar in 2005.

Mainland banks are making their demands through the use of China’s new derivatives master agreement, which was introduced in March.

FSA on regulating OTC derivatives

Risks highlighted by the financial crisis

1.1 The financial crisis has highlighted deficiencies within the over-the-counter (OTC) derivative markets: most notably shortcomings in the management of counterparty credit risk and the absence of sufficient transparency. This paper sets out the steps required to address these issues, where relevant identifying further necessary work streams.

1.2 In summary, the Treasury and the FSA (‘UK Authorities’) propose that the following measures need to be implemented and/or developed to address systemic shortcomings in OTC derivative markets:

  • Greater standardisation of OTC derivatives contracts. Greater standardisation would enhance the efficiency of operational processes; facilitate the increased use of central counterparty (CCP) clearing and trading on organised trading platforms, and support greater comparability of trade information.We will work with international regulators and the industry to take steps to identify and agree which products can be further standardised, both in terms of underlying contract terms and operational processes, and ensure that this is implemented on a timely basis.
  • More robust counterparty risk management. All OTC derivative trades, whether or not centrally cleared, should be subject to robust arrangements to mitigate counterparty risk. For all financial firms this should be through the use of CCP clearing for clearing eligible products. For trades which are not centrally cleared these should be subject to robust bilateral collateralisation arrangements and appropriate risk capital requirements. This approach may differ for non-financial firms given the different nature of the risks they pose to the financial system.

It is important that all participants bear the cost of managing the risk they pose.

Consistent and high global standards for Central Counterparties (CCPs).

Increased use of CCPs will heighten their systemic importance so it is crucial that they are regulated to high standards, consistently applied in the major jurisdictions.

We are working in CPSS-IOSCO and the Basel committees to revise existing standards. In Europe, the UK has been leading calls for a Clearing Directive and will press to ensure this is an effective tool in mitigating any risk that CCPs will pose to the financial system.

  • International agreement as to which products are ‘clearing eligible’. This will require

assessment by both regulators and CCPs in deciding which products are eligible for clearing. In addition to the degree of standardisation, consideration must also be given to the regular availability of prices; the depth of market liquidity; and whether the product contains any inherent risk attributes that cannot be mitigated by the CCP. Once clearing eligible products are identified, regulators should set challenging targets for CCP usage with active monitoring of progress against these rather than mandate the use of CCP clearing.

  • Capital charges to reflect appropriately the risks posed to the financial system. These should be higher for non-centrally cleared trades and we are working through the Basel Committee to deliver a proportionate approach. Capital charges for exposures to CCPs should also be risk-based.
  • Registration of all relevant OTC derivative trades in a trade repository. This will facilitate regulators having appropriate access to the information they need to fulfil their regulatory responsibilities. We are working through the OTC Derivative Regulators Forum (ORF) to deliver this across a number of asset classes.
  • Greater transparency of OTC trades to the market. Access to better information around prices and volumes can help price formation and market efficiency. However, this should be calibrated to minimise scope for an adverse impact on liquidity, and consideration should be given to using existing reporting channels to minimise costs.
  • On-exchange trading. Once these steps have been taken we do not see at this stage the need for mandating the trading of standardised derivatives on organised trading platforms. Regulatory objectives of reducing counterparty risk and improving transparency can be achieved by other means and we will review progress of initiatives in this area. Moreover, mandating the use of organised platforms would imply a regulatory imposition of trading structure, which we do not believe is necessary.

1.3 This paper sets out our detailed thinking on each of these key issues as well as outlining our approach for taking these measures forward.

UK opposes mandatory exchange trading of derivatives

Banks should not be forced to shift privately-negotiated derivatives transactions onto exchanges, Britain’s Financial Services Minister, Paul Myners, said on Tuesday.

“We do not see the need for mandating trading of standardised derivatives on organised trading platforms,” Myners told a committee of parliament’s upper chamber.

The G20 group of countries agreed last year that standardised over-the-counter derivatives should be centrally cleared and, where appropriate, traded on an exchange or other type of electronic platform.

This is seen as cutting risk and increasing transparency in a sector whose opaqueness alarmed regulators during the height of the financial crisis.

U.S. insurer AIG, which nearly collapsed, and Lehman Brothers bank, which went bust in 2008, were both closely linked to the derivatives sector.

The European Union and United States are putting the G20 pledges into law but the latter is pushing hard for exchange trading of OTC contracts, which has pleased some exchanges but alarmed dealers and customers.

Myners said it was important to have a coordinated global approach to derivatives to avoid banks playing one jurisdiction against another.

Several central counterparties are emerging or set to emerge to clear the vast $450 trillion over-the-counter derivatives market, such as ICE <ICE.N> in Europe and the United States.

New EU rules would enable new central counterparties authorised in one member state to operate across the 27-nation bloc, ensure high governance standards and rights of access to all users, Myners said.

Britain sought to fend off any fresh attempts to centralise authorisation of central counterparties in the EU where financial supervision is being overhauled.

“Responsibility for authorisation and supervision of central counterparties should remain at the national level. Central counterparties will be of increasing systemic importance,” Myners said.

Big companies like airlines say hedging some risks such as fuel prices can only be done through bespoke OTC contracts that cannot be centrally cleared let alone exchange traded.

The EU’s executive European Commission has signalled that it will accommodate this by slapping capital charges on OTC trades that are not centrally cleared.

Myners said it was essential not to make it difficult for companies to hedge risks through privately-negotiated derivatives contracts due to penal capital charges.

The European Commission is due to publish a draft law on derivatives clearing by July which will need approval from member states and the European Parliament to take effect.

The House of Lords published a report entitled "The future regulation of derivatives markets: is the EU on the right track?" (HL 93). The report focuses on the European Commission's studies of OTC derivative regulation.

The House of Lords' report supports regulatory legislation of OTC derivatives, including the use of trade repositories to record OTC derivatives and ensure all trades in the market are reported. The report also supports efforts to standardize derivative products and the use of central clearing. However, the report did note that not all products are suitable for standardization and central clearing and that exceptions must be made for some bespoke derivatives to ensure an efficient market. The report also expresses some systemic risk concerns about the ability of the EU to effectively regulate trade clearinghouses.

EC delays derivatives reform proposals to 2010

"Further reform of the over-the-counter derivatives market expected from the European Commission (EC) tomorrow is likely to take the form of soft recommendations rather than legislative proposals and could be delayed until later in the week, according to an EC official.

The EC published a communication on possible reforms on July 3, to include greater use of central counterparties (CCPs) for clearing OTC derivatives and central data repositories, as well as a possible push towards exchange trading. Having received 99 responses to its industry consultation, the EC held a conference in Brussels on September 25 and said it would work to come up with "operational conclusions" on October 20.

But the EC's formal mandate is due to end on October 31, after which it will assume a caretaker position until the New Year, meaning it cannot legally undertake new initiatives but will simply manage day-to-day business. Consequently, there is not enough time for the EC's internal market and services directorate-general, headed by Charlie McCreevy, to put its ideas into legislative practice. The next commission is expected to take office early in 2010, but the exact date will depend on the resolution of continuing disputes over the Lisbon Treaty.

"This week's statement will be a communication, which means setting out options to be taken rather than a legislative text. It will obviously be based on feedback from the consultation, but of course the bigger question in the near future will be whether we go for strong legislation on this in Europe. That will be a question for the next commission to answer," says a spokesman for Charlie McCreevy. He adds the communication will be discussed at a meeting of the EC on October 20, and will be published at the earliest that evening, but more probably on October 21 or 22.

Dealers and end-users have voiced concern over some aspects of the EC's proposals, including the suggestion incentives may be put in place to encourage the clearing of contracts through CCPs. Some have suggested there could be a moral hazard if regulators push greater volumes towards CCPs, which in turn would have a commercial incentive to clear as much as possible. Rather than mitigating risk, this could just concentrate risk on a single entity and make the CCPs systemically threatening.

The establishment of the OTC Derivatives Regulators’ Forum

"International regulators announced today the establishment of the OTC Derivatives Regulators’ Forum. Since January 2009, international regulators have been meeting periodically to exchange views and share information on developments related to central counterparties (CCPs) for over-the-counter (OTC) credit derivatives (CDS).1 Based on the success of this cooperation, the OTC Derivatives Regulators’ Forum has been formed to provide regulators with a means to cooperate, exchange views and share information related to OTC derivatives CCPs and trade repositories. The objectives of the Forum are to:

  • Provide mutual assistance among the regulators in carrying out their respective authorities and responsibilities with respect to OTC derivatives CCPs and trade repositories, and with respect to the broader roles and implications of these infrastructures in the financial system;
  • Promote consistent public policy objectives and oversight approaches for OTC derivatives CCPs and trade repositories, including the development of international cooperative oversight arrangements that may be applied to individual systems;
  • Adopt, promote, and implement consistent standards, such as the CPSS-IOSCO Recommendations for Central Counterparties (RCCPs), in setting oversight and supervisory expectations;
  • Coordinate the sharing of information routinely made available to regulators or to the public by OTC derivatives CCPs and trade repositories;
  • Effectively deal with common issues collectively and consistently; and
  • Encourage strong and open communication within the regulatory community and with the industry.

The OTC Derivatives Regulators’ Forum is comprised of international financial regulators including central banks, banking supervisors, and market regulators, and other governmental authorities that have direct authority over OTC derivatives market infrastructure providers or major OTC derivatives market participants, or consider OTC derivative market matters more broadly. See appendix 1 for a list of regulators and authorities currently involved in the Forum.

European Commission oversight

Source:Media release from the EU

The European Commission has adopted a Communication on ensuring efficient, safe and sound derivatives markets, following a commitment made in the Communication on 'Driving European recovery' (IP/09/351 ).

The Communication looks at the role played by derivatives in the financial crisis and at the benefits and risks of derivatives markets, and assesses how risks can be reduced. Following the public consultation which this Communication launches, the Commission will host a public hearing on 25 September 2009.

Taking into account the outcome of the consultation, the Commission will draw operational conclusions before the end of its current mandate and present appropriate initiatives, including legislative proposals as justified, before the end of the year to increase transparency and ensure financial stability.

This Communication marks another step in the Commission's efforts to strengthen the financial system in view of the failings unearthed by the financial crisis. It responds to the commitment contained in the Communication of 4 March and is fully in line with the principles adopted by the G20 and the recommendations of the de Larosi è re Group.

The Commission stands ready to work with authorities around the world to ensure global consistency of policy approaches and to avoid any risk of regulatory arbitrage.

Internal Market and Services Commissioner Charlie McCreevy said "Derivatives markets play an important role in the economy but the crisis has shown that they may harm financial stability. As regards credit default swaps (CDS), industry has committed to clear CDS on European reference entities and indices on these entities through one or more European CCPs by 31July 2009. I expect industry to move clearing of CDS to any European CCP that has received regulatory approval for clearing indices and single names by that deadline."

Taking into account the wide diversity of 'over the counter' (OTC) derivatives markets, the Communication outlines the tools to ensure that they do not harm financial stability. These tools, which can be combined with each other, are:


This would enhance operational efficiency and reduce operational risks. It could be achieved by encouraging broader take up of standard contracts and electronic affirmation and confirmation services, central storage, automation of payments and collateral management processes. This requires investments and it may therefore be necessary to incentivise these investments.

Central data repositories

Such repositories collect data on, for example, number of transactions and size of outstanding positions. This increases transparency, knowledge and contributes to operational efficiency. Currently, such a repository exists for Credit Default Swaps (CDS)] 1 , and could potentially be used for other derivatives segments as well. European securities regulators (CESR) are currently carrying a feasibility study for data repository based in the European Union. In the light of the forthcoming CESR report, the Commission will decide on appropriate actions.

Central Counter-party (CCP) clearing

CCPs have proven their worth during the financial crisis. In view of those benefits, the Commission has since October 2008 worked with industry to ensure that clearing of CDS takes place on European CCPs. Industry has as a result committed to achieve CCP clearing by 31 July 2009. If industry is unable to deliver on this commitment, the Commission will have to consider other ways to incentivise the use of CCP clearing. The Commission also considers that the broader use of CCPs in other OTC derivatives markets should be incentivised, wherever possible.

Trade execution on public trading venues

For standardised derivatives that are cleared by a CCP, the question arises whether the trading of these contracts should take place on an organised trading venue where prices and other trade-related information are publicly displayed (e.g. a regulated market). This would improve price transparency and strengthen risk management. However, it could come at a cost in terms of satisfying the wide diversity of trading and risk management needs.

The Commission will examine, taking into account the bespoke and flexible nature of OTC derivatives markets and the regime applicable to cash equities, how to arrive at a more transparent and efficient trading process for OTC derivatives. In this respect the Commission will further assess

  • (i) the channelling of further trade flow through transparent and efficient trading venues and
  • (ii) the appropriate level of transparency (price, transaction, position) for the variety of derivative markets trading venues.

The Communication also highlights the actions already undertaken in response to the financial crisis in the area of derivatives (e.g. CCP clearing for CDS, securitisation, credit rating agencies and hedge funds and other alternative investment management funds, supervision).

The Commission services have also issued two Staff Working Papers. The first one analyses OTC derivatives markets and the second one is a consultation document containing a more detailed questionnaire. The consultation will be open until 31 st August 2009. Responses can be addressed to

China’s state-owned enterprises may terminate contracts

Some of China's biggest airlines and shippers lost hundreds of millions of dollars last year on derivative trades when the price of oil plunged. They are now seeking to claw back those losses.

In a statement on its website, the state-owned Assets Supervision and Administration Commission said it supported moves by unnamed Chinese enterprises to seek recourse for their losses in structured financial derivative contracts tied to the price of oil and reserved the right to file lawsuits itself.

"The move is a very normal action for enterprises to use legal tools to protect their deserved rights in commercial activities," said the one-paragraph SASAC statement.

The commission is Beijing's umbrella organisation responsible for companies owned by the central government, including 150 major state-owned enterprises.

With concern already rising in recent weeks that Beijing might challenge the fuel-derivative losses, bankers have been scurrying to protect themselves.

One day last week, trading in certain contracts all but shut down in China, bankers say. Now, bankers are discussing how to impose stiffer collateral requirements for Chinese airlines and other companies that seek derivative contracts.

"It significantly increases the cost for Chinese airlines," one person familiar with the matter said of the effort to require more collateral.

The statement is the latest reminder of how Beijing is ready to adopt forceful methods to support its resource-hungry companies.

Last month, Shanghai police formally arrested four employees of Anglo-Australian miner Rio Tinto on suspicion they illegally procured information to use in negotiating a multibillion-dollar deal to supply Chinese steel makers with iron ore.

In early August, China Eastern Airlines, Air China and China Ocean Shipping sent letters to six international investment banks warning that certain transactions "may be void, invalid or unenforceable," said a person familiar with the letters.

Among the banks understood to have received such letters are Deutsche Bank, Goldman Sachs Group, JPMorgan Chase, Citigroup and Morgan Stanley, according to three people familiar with the situation.

China Eastern entered into complex deals called "collar structures" designed to keep fuel prices within a range and which included buying and selling a basket of options. When oil prices unexpectedly plunged last year along with other financial markets, the airline faced deep losses, according to disclosures by the company and bankers familiar with the matter.

The Shanghai-based carrier said in January it faced a loss of about $US900 million ($1.05 billion) on aviation-fuel-hedging activities. In a reminder of how volatile financial markets can be, it more recently said its position had reversed.

China Eastern chairman Liu Shaoyong declined to comment on the government statement but said he expects Beijing to issue new rules on the use of derivatives. He noted that hedging is a "normal" business activity. Air China and China Ocean Shipping also declined to comment.

Lawyers said Beijing's statement is startling. The government is "actively encouraging Chinese state-owned companies to cut their losses by taking various actions, including legal actions," said Alan Wang, a partner at Freshfields Bruckhaus Deringer.

By stepping into oil-derivative contract disputes that have been bubbling for months, Beijing is sending a signal that its strategic interests can extend to foreign financial markets.

That is important because as Chinese companies go abroad to procure commodities, global banks are finding big new customers for hedging contracts and other derivatives deals that aim to capture profits, offset losses and offer stability to the purchase deals.

Chinese leaders are concerned that state-owned companies, stepping outside the protective walls of the government-planned economy in search of natural resources overseas to power their rapid expansion, are easy targets for globally savvy resources suppliers and financial institutions.

The SASAC highlighted in its statement that it is investigating the oil contracts in order to "safeguard state assets," while noting the "risks and complexities" in some contracts that make them difficult to understand.

When financial markets have tripped up state companies in the past, Beijing has sometimes sought to distance itself from obligations.

Five years ago, a Chinese trading firm in Singapore lost $US550m on trades in fuel contracts. Shortly afterward, the SASAC and the trading firm's parent company, state-owned China Aviation Oil Holding, issued statements saying any losses were the fault of the Singapore subsidiary and called on counterparties to be "realistic" in their expectations of repayment.

About two years ago, the Chinese company settled its claims, paying less than estimates of the initial losses, a lawyer involved in the case said.

The government statement reiterates warnings that Chinese companies are permitted to enter derivative contracts only to hedge, or protect themselves from swings in commodity prices, and not to speculate. The policy is backed up by numerous rules, which bankers said could be tightened further.

Some in the industry believe that foreign banks will face pressure to offer derivatives through domestic Chinese financial institutions, presumably so their activity could be better monitored by Beijing. Already, China has made vigorous efforts to bring more such activity onshore through Chinese commodity markets and over-the-counter trading regulated domestically.

Financial policy makers in China say government leaders often don't grasp how derivative products work and then react angrily when deals backfire.

Mr Wang at Freshfields said the recent events highlight the need for foreign institutions to ensure that Chinese entities have necessary authorisation to enter a deal, since legal challenges are often grounded in an argument that the deals weren't permitted or were too complex.

Also, contracts should specify that disputes will be settled via international arbitration, since China won't typically enforce foreign court decisions."

"China’s state-owned enterprises may unilaterally terminate commodities contracts as they try to cut massive losses from financial derivatives, an industry source told Caijing on August 28.

According to the source, China’s State-owned Assets Supervision and Administration Commission (SASAC) has sent notice to six foreign financial institutions informing them that several state-owned enterprise will reserve the right to default on commodities contracts signed with those institutions.

Keith Noyes, an official with the International Swaps and Derivatives Association, a trade organization, confirmed that he is aware of the SASAC letter, but provided no further comment.

Foreign brokerages usually work through their Hong Kong operations to sign over-the-counter derivative hedging contracts, according to an investment banker whose firm is involved in the business. Hong Kong and Singapore usually serve as venues for arbitration over such transactions.

Most investment banks may "just swallow" any losses arising from canceled contracts, the executive said, adding that any losses are usually made up for with compensating trades.

Investment banks "just earn less" from such transactions, he said.

But any such move would be a major blow to investment banks which service massive commodities hedging operations for Chinese SOEs on the international market, said the executive.

Chinese SOEs have suffered massive losses from hedging contracts since the onset of the global financial crisis. SASAC and the National Auditing Office has been investigating derivatives positions trading since the beginning of the year.

A source from a state-owned company told Caijing that most of China’s SOEs engaging in foreign exchange and international trade have participated in derivatives trading, involving capital topping 1 trillion yuan."

Islamic banks restricted from using derivatives

"... Islamic banks have grown substantially in recent years, with their assets currently estimated at close to $850 billion. Overall, the risk profile of Islamic banks is similar to conventional banks in that the risk profile of Shariah-compliant contracts is largely similar to that in conventional contracts, and credit risk is the main risk for both types of banks.

Unlike conventional banks, however, Islamic banks are not permitted to have any direct exposure to financial derivatives or conventional financial institutions’ securities—which were hit most during the global crisis.

An analysis of the top 50 banks in the GCC indicates that conventional banks also had this advantage going into the crisis—direct exposure to equity investments (and derivatives in the case of conventional banks) were very low in both types of banks (a mere 1 percent of total assets in conventional banks and 2 percent for Islamic banks in 2008). "

India bans SocGen and Barclays from derivatives market

"Societe Generale SA’s Indian unit was ordered to stop selling or trading offshore derivatives by the nation’s capital markets regulator, which said the bank failed to provide fair and complete information about its trades.

The Securities & Exchange Board of India gave Societe Generale, France’s second-largest bank, 30 days to reply or file an objection to the order, according to a statement posted on its Web site yesterday.

The Paris-based company is the second overseas bank to be suspended from trading derivatives by the regulator in just over a month. Barclays Plc suspended sales of its exchange-traded notes linked to Indian stocks following a Dec. 9 order. Both banks gave incorrect details on the sale of so-called participatory notes, the regulator said.

“Societe Generale completely failed in obtaining correct and complete information from the counterparties it deals with,” the regulator’s statement said. “Societe Generale is required to show cause as to why appropriate proceedings including cancellation of its certificate of registration as a foreign institutional investor should not be initiated.”

The French bank said in a statement that it’s “cooperating fully” with the investigation and aims to provide all the information required within the 30-day period demanded by the regulator. Melody Jeannin, a spokeswoman in Paris, declined to comment beyond the statement.

Reliance Shares

Jonathan Williams, Barclays Capital’s Singapore-based spokesman, didn’t answer calls made to his mobile phone after hours. Barclays said on Dec. 9 that it was cooperating fully with the regulator.

Both banks reported incorrect data on transactions involving instruments linked to shares of Reliance Communications Ltd. to Hythe Securities Ltd., according to the regulator’s statements..."

The Boca Resolution

Source: [5] CFTC, 1996, amended in 1998

Declaration on Cooperation and Supervision of International Futures Markets and Clearing Organisations.

1.1. This Declaration is made in the light of, and to augment, the Memorandum of Understanding and Agreement executed contemporaneously at Boca Raton, Florida on March 15, 1996 (the “MOU”) by certain futures exchanges and clearing organizations (“Parties”).

1.2. Each of the supervisory authorities that is an initial signatory to this Declaration or that subsequently adheres to it (the “Authorities”), exercises governmental responsibilities in supervising and/or otherwise acting in respect of, a futures exchange or clearing organization.

1.3. The Authorities endorse the MOU as an effective measure to facilitate and strengthen the sharing of relevant information between Parties in order to improve their cooperation, particularly in respect of potential hazards to the stability, safety and soundness of the international financial markets.

1.4. The Authorities further endorse the recognition in the MOU that the Parties can assist each other in the discharge of their respective supervisory duties as market authorities, and in some cases as self-regulatory ecognizeons, by sharing information as described. They note the requirements in the MOU to frame requests in the event of certain triggering events or conditions to secure the specific information necessary to respond to particular events and developments, and the commitment to continued dialogue and information exchange. They believe that the provisions in the MOU to ensure appropriate confidentiality and use of information received will encourage the effective functioning of the arrangements set out in the MOU. They also welcome the acknowledgement that Parties may ask their supervisory Authority to make information available to another Party’s supervisory Authority where appropriate.

1.5. The Authorities also ecognize that the Parties may be impeded by laws or circumstances from being able to provide the necessary information directly. In desiring generally to promote the sharing of information necessary to strengthen regulatory supervision, ecogniz systemic risk, prevent or limit potential abusive or manipulative practices and enhance customer and investor protection, the Authorities hereby intend, by use of the most appropriate lawful means at their disposal, to seek to assist Parties by communicating directly with an appropriate counterparty wherever possible and appropriate in their efforts to provide the information required.

1.6. The Authorities accordingly establish the following machinery to carry these purposes into effect.

Lehman bankruptcy court says swap agreement unenforceable

When Lehman Brothers Holdings, Inc. filed for bankruptcy protection on September 15, 2008, Lehman (directly and through its subsidiaries and affiliates) was party to more than 900,000 derivative contracts. Termination of these contracts may require Lehman or its counterparties to make lump-sum termination payments to the other. As Lehman accelerates its efforts to liquidate and monetize as many of these contracts as possible, the first handful of swap-related cases have made their way onto the bankruptcy court docket, which has now become a forum to test the scope and limits of many of the "safe harbor" provisions afforded to swaps, derivatives and other financial contracts under the Bankruptcy Code. Never have so many contracts come under such intense legal scrutiny for the first time, at one time, in the same court.

A number of counterparties to Lehman have commenced adversary proceedings seeking to adjudicate their rights under these agreements, and Lehman has filed a number of motions to collect unpaid amounts it believes are due under these agreements. On September 17, in one such closely watched matter, U.S. Bankruptcy Judge James Peck ordered Metavante Corporation ("Metavante"), a counterparty to Lehman Brothers Special Financing ("LBSF") in an interest rate swap transaction in which Lehman Brothers Holdings, Inc. ("LBHI") is the credit support provider, to perform its obligations to pay quarterly fixed amounts owing under the transaction, notwithstanding the bankruptcies of LBSF and its parent. Judge Peck concluded that Metavante could not rely solely on the filing of the Lehman bankruptcy cases to refuse to make payment to Lehman while also not terminating the agreement. More specifically, Judge Peck found that:

  • the swap agreement is "in fact, a garden variety executory contract, one for which there remains something still to be done on both sides," and as such is "enforceable by a debtor against the counterparty;"
  • the safe harbor provisions available to swap counterparties under Sections 560 and 561 of the Bankruptcy Code are limited to the counterparties' right (i) to liquidate, terminate or accelerate its contracts or (ii) to net out its positions; and
  • Metavante's reliance on the standard condition precedent provision of Section 2(a)(iii) of the ISDA Master Agreement to excuse its payment indefinitely due to Lehman's bankruptcy was counter to Congress's intent to allow for "prompt closing out" and "immediate termination for default."

Ultimately, Judge Peck stated that, by 11 months after the commencement of the case, the failure to exercise the right to terminate the swap "constitutes a waiver of that right." Under his interpretation, counterparties risk waiving their rights to terminate their contracts if they fail to exercise their rights "fairly contemporaneously with the bankruptcy filing." As this is the first time the issue has been addressed by a U.S. court, the ruling may have widespread ramifications not only for other outstanding Lehman transactions but for the rights of all parties to derivatives transactions prospectively.

Who Is "In The Money" And Who Is "Out Of The Money"?

As noted earlier, the timely settlement and liquidation of outstanding derivatives transactions constitute one of the primary objectives of the Lehman bankruptcy estates. By Lehman's own count, as of June 2009, there were still hundreds of outstanding swaps and other derivatives contracts in which Lehman was "in the money" (i.e., it would be owed a payment upon early termination rather than being required to make one). The "out of the money" counterparties face difficult decisions as a result of the bankruptcy cases. Under the terms of the ISDA Master Agreement1 under which the vast majority of these transactions are documented, the counterparty, as the non-defaulting party, has the right (but not the obligation) to terminate a transaction early or to let it continue.

A transaction that is out of the money for a counterparty today may be in the money tomorrow, or at least at sometime prior to its scheduled termination date. Accordingly, the dilemma for these counterparties has been whether or not to continue to perform on these contracts, making payments to Lehman as and when required, in the hope that Lehman might be able to satisfy its obligations at such future time that the markets would move in the counterparties' favor. With Lehman in Chapter 11, many counterparties may have concluded that Lehman was unlikely to ever be in a position to perform and therefore elected (i) not to terminate their transactions, but also (ii) to withhold any required periodic payments to Lehman in reliance on Section 2(a)(iii) of the Master Agreement. Section 2(a)(iii) provides that the obligation of a party to perform under a transaction is subject to the condition precedent that "no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing."

Whether, and for how long, a non-defaulting party may exercise these "wait and see" rights is a question that had not been addressed by a U.S. court2 before the Lehman bankruptcy cases, but was among the issues that Judge Peck considered in Metavante.

The Metavante Decision

In November 2007, Metavante entered into an amortizing interest rate swap transaction with LBSF with a notional amount of $600 million under which LBSF, as floating amount payer, agreed to make quarterly payments based on a floating interest rate. Metavante, as the fixed amount payer, agreed to make payments based on a fixed interest rate. Under the transaction, the swapped payments were netted, as is customary, and only the party with a net payment obligation was required to pay the other party on each payment date. The transaction was documented in a 1992 ISDA Master Agreement and customary trade confirmation. LBSF's obligations were unconditionally guaranteed by LBHI.

On September 15, 2008, LBHI filed for bankruptcy under Chapter 11 of the Bankruptcy Code. Shortly thereafter, on October 3, 2008, LBSF commenced its own Chapter 11 bankruptcy case. Under Section 5(a)(vii) of the Master Agreement, the bankruptcy filings by LBHI and LBSF each constituted a separate event of default by Lehman, each of which entitled Metavante, as the non-defaulting party, to designate an early termination date for the transaction if it so chose. Upon early termination, the Master Agreement generally provides for the transaction to be valued in light of current market rates and otherwise in accordance with certain payment measures and methods specified in the contract. The party determined to be out of the money based on those calculations must make a termination payment to the other party, regardless of which is the defaulting party. Based on Lehman's and Metavante's filings in the proceeding, upon an early termination of the swap, Metavante would likely have been obligated to make a significant lump-sum payment to LBSF.

In reliance on the "wait and see" provision of Section 2(a)(iii) of the Master Agreement, Metavante chose to neither terminate nor perform. Based on Lehman's and Metavante's filings in the proceeding, Metavante owed periodic net payments to LBSF under the swap transaction but Metavante had not made any of these payments since the Lehman bankruptcy filings.

In May 2009, Lehman filed a motion to compel performance of Metavante's obligations, asserting that the swap was an executory contract and arguing for a "straightforward application" of Section 365 of the Bankruptcy Code. Specifically, Section 365(e)(1) of the Bankruptcy Code prevents parties from modifying rights of a debtor under an executory contract "at any time after commencement of the case solely because of a provision in such contract . . . that is conditioned on . . . the commencement of a case under this title . . . ." Lehman argued therefore that Section 2(a)(iii) of the Master Agreement was void and unenforceable as an ipso facto clause because permitting a party to indefinitely delay performance in reliance on that provision effectively modified LBSF's rights solely as a result of the commencement of the bankruptcy cases.

In its motion, Lehman acknowledged that the Bankruptcy Code provides for a safe harbor that exempts the exercise by a swap participant (or certain other derivative contract counterparties) of "any" contractual right arising under a swap agreement (or other derivative contract) and permits a swap participant, among other things, to "offset or net out any termination value, payment amount, or other transfer obligation" under any related transaction.3 While the scope of the safe harbor is expansive in terms of the types of covered transactions, Lehman argued that the safe harbor itself is limited to exercise of the stated remedies only (i.e., liquidate, terminate, accelerate and offset) and did not [give] license [to] other modifications of the debtor's rights by counterparties.

Conversely, Metavante argued that the terms of the Master Agreement were clear and unambiguous: the non-defaulting party had the right, but not the obligation, to terminate all outstanding transactions, and Section 2(a)(iii) permitted the non-defaulting party to suspend its performance while an event of default was continuing, with no applicable time limit. In its filings, Metavante declared that the "right to elect to terminate – or not terminate – the swap at any time prior to maturity is an essential and critical right of a non-defaulting party."4 Metavante further noted that a ruling in favor of Lehman's motion would deprive it of its rights to net/set-off any damages arising from the termination since the non-defaulting party has the right of set-off only upon its designation of an early termination date on account of the other party's default.

Judge Peck sided with Lehman. In granting the motion, he concluded that the safe harbor provisions of the Bankruptcy Code "protect a non-defaulting swap counterparty's contractual rights solely to liquidate, terminate or accelerate" derivatives transactions upon the bankruptcy of their counterparty, or to "offset or net out any termination values or payment amounts" in connection with such a termination, liquidation or acceleration. By "simply withholding performance," Metavante was not attempting to take any of these actions and was thus not protected by the Bankruptcy Code safe harbors. Judge Peck then found that the contract between Metavante and Lehman was a "garden variety executory contract," subject to the general executory contract principles of the Bankruptcy Code.

Finally, though the Bankruptcy Code itself is silent as to a time-frame within which a non-defaulting counterparty must act to exercise its termination and other rights contemplated under the safe harbor, Judge Peck held that "Metavante's window to act promptly under the safe harbor provisions has passed, and while it may not have had the obligation to terminate immediately" upon Lehman's bankruptcy filing, its failure to exercise its statutory rights at this point in the case had resulted in a waiver of those rights.


There are many other derivative and financial contract transactions either pending before the Lehman bankruptcy court or that have yet to be brought before the court – some similar to Metavante and others with minor or major variations on the facts. For example, on August 27, 2009, the Board of Education of the City of Chicago filed a complaint seeking a declaratory judgment in connection with its own interest rate swap with LBSF, under which LBHI was the guarantor as well. The Board of Education similarly has not made payments otherwise required to be made by it under its swap contract and it too is relying at least in part on the "wait and see" provision of Section 2(a)(iii).

its complaint, the Board of Education adds that the primary event of default upon which it is relying is not the bankruptcy filing by LBSF, its counterparty, but the pre-petition event of default that occurred when LBHI, as guarantor, failed to pay its debts as they became due and filed for bankruptcy protection. The Board of Education is arguing at least initially that Section 365(e) of the Bankruptcy Code, which prohibits contracts from containing an event of default conditioned solely upon the financial condition of the debtor, is inapplicable to its contract with Lehman because the relevant event of default relates to the financial condition of the guarantor, LBHI. Whether the Bankruptcy Court will be more receptive to this argument (which appears to be equally applicable to the facts of Metavante) remains to be seen.

The court's rulings in Metavante also evoke a number of questions. For example, first, embedded in the decision without significant discussion is the finding that a swap is a "garden variety" executory contract and not a contract for "financial accommodation" that would preclude application of the executory contract principles under Section 365. Second, while the Bankruptcy Court's ruling indicates that 11 months is long enough to constitute a waiver of a non-defaulting party's right to terminate outstanding transactions upon the other party's default, the court did not answer the question as to when such a waiver actually occurred or became effective.

Neither the relevant safe harbor provision of the Bankruptcy Code nor Section 365 of the Bankruptcy Code addresses this issue, directly or indirectly. Third, it remains an open question as to whether other events of default or potential events of default (i.e., defaults other than those arising from the filing of a bankruptcy case) would be sufficient to excuse payment in reliance Section 2(a)(iii) of the Master Agreement. Nuances in facts and interpretations may give rise to additional questions, of course, especially as the court continues to address similar cases.

The Lehman cases may offer answers to these and other questions for those parties that come before the court with different contractual arrangements. More of these disputes are scheduled to be heard on October 15, 2009. If Lehman or any of its counterparties appeals an adverse ruling, then additional guidance may develop. Finally, market participants will closely observe the results in these cases and perhaps reconsider the Master Agreement forms in light of what has occurred. The sheer quantity and complexity of transactions to which Lehman was a party makes the Lehman bankruptcy cases a testing ground for the treatment of derivative financial contract agreements under the Bankruptcy Code and will certainly impact how these agreements are negotiated long into the future.


1. The ISDA Master Agreement is published by the International Swaps and Derivatives Association, Inc. While there are two versions of the Master Agreement currently in use, the 1992 and 2002 forms, the provisions of the Master Agreement discussed in this Alert (Sections 2(a), 5 and 6) are substantially similar as between the two versions.

2. In a widely reported 2003 Australian case, Enron Australia v. TXU Electricity Ltd, the court declined to depart from the plain meaning of the provision, permitting TXU to withhold performance under Section 2(a)(iii) indefinitely. Specifically, the court found that the bankruptcy laws did not permit it "to deprive the counterparty of its contractual rights, such as the right not to designate an Early Termination Date . . . and the right under section 2(a)(iii) not to make a payment."

3. Absent these safe harbor provisions, the Bankruptcy Code would preclude swap participants (or certain other derivative contract counterparties) from liquidating agreements or realizing against any property posted as collateral (without first obtaining relief from the automatic stay in bankruptcy court).

4. Objection of Metavante Corporation to Debtors' Motion pursuant to Sections 105(a) and 365 of the Bankruptcy Code, to Compel Performance of Obligations under an Executory Contract and to Enforce the Automatic Stay at 13 (June 15, 2009).

Lobbying for derivatives

See Derivatives lobbying.

Derivative accounting standards

See Derivatives accounting

OTC and exchange-traded

Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way they are traded in market:

  • Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary.

Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way.

The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other often sophisticated parties, such as hedge funds.

Reporting of OTC trade amounts can occur in private, without activity being visible on any exchange.

According to the Bank for International Settlements, the total outstanding notional amount is $684 trillion (as of June 2008)

The BIS survey:

The Bank for International Settlements (BIS) semi-annual OTC derivatives statistics report, for end of June 2008, shows $683.7 trillion total notional amounts outstanding of OTC derivatives with a gross market value of $20 trillion.

See also Prior Period Regular OTC Derivatives Market Statistics).

Of this total notional amount,

Because OTC derivatives are not traded on an exchange, there is no central counterparty. Therefore, they are subject to counterparty risk, like an ordinary contract, since each counterparty relies on the other to perform.

  • Exchange-traded derivatives (ETD) are those derivatives products that are traded via specialized derivatives exchanges or other exchanges.

A derivatives exchange acts as an intermediary to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee.

Derivatives exchanges (by number of transactions) are the:

  • Exchange (which lists KOSPI Index Futures & Options)
  • Eurex (which lists EU products such as interest rate & index products)
  • CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008 acquisition of the New York Mercantile Exchange).

According to Bank for International Settlements, the combined turnover in the world's derivatives exchanges totalled USD 344 trillion during Q4 2005.

Some types of derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges.

Also, warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs and various other instruments that essentially consist of a complex set of options bundled into a simple package are routinely listed on equity exchanges.

Like other derivatives, these publicly traded derivatives provide investors access to risk/reward and volatility characteristics that, while related to an underlying commodity, nonetheless are distinctive.

Clearing and defining what is standard

Addressing a theme that recurs in all the discussions about OTC derivatives regulation, the Treasury framework recommends the amendment of the Commodities Exchange Act (CEA) and the securities laws so that all "standardized" OTC derivatives are required to be cleared through regulated central counterparties (CCPs). Furthermore, the CCPs should be required to impose "robust margin requirements as well as other necessary risk controls."

Treasury has reiterated that "customized" OTC derivatives should not be used to avoid using a CCP, with the creation of a presumption that a contract is standardized if an OTC derivative is accepted for clearing by a CCP.

In addition, Treasury recommends moving "the standardized part of these markets" onto regulated exchanges and regulated transparent electronic trade execution systems for OTC derivatives and requiring a system for the reporting of trade details.

Further, Treasury continues to suggest that regulated financial institutions be encouraged to make greater use of regulated exchange-traded derivatives. These recommendations are presented as a means to contain systemic risk and to improve market efficiency and price transparency.

It is still unclear what parameters would establish whether a product is standardized and, once that is determined, which contracts are to be cleared via CCPs, traded on an electronic trading platform or quoted on a regulated exchange.

Who will determine whether and how to classify a derivative as standardized has not been identified. As we have noted before, since some contracts would be presumed to be standardized because of their acceptance by a CCP, it would appear that there is a voluntary component in the initial decision to submit a trade to a CCP. Which derivatives will be required (versus elected) to be traded in a certain manner is still an open question and no distinctions are being made among various OTC derivatives, some of which may be ill-suited to any of these trading options.

"We would like to highlight that there should be an explicit obligation on access and interoperability for the CCPs on CDS within the supervisory framework of the Recommendations as an essential prerequisite for a vital and undistorted competition between the relevant market infrastructures. Neglecting this prerequisite could cause severe market distortions. Especially smaller and medium-sized market participants would not be able to establish a connection to all upcoming CCPs for the CDS market with the consequence that their brokerage clients will change to clearing members. This could lead to distortions of the CDS market in the sense of oligopolistic structures."

See also CDS clearing


Total world derivatives from 1998-2007 compared to total world wealth in the year 2000
Total world derivatives from 1998-2007[1] compared to total world wealth in the year 2000
  • Lacima riskAnalytics Price, quantify risks, manage and optimize financial positions and physical assets within a single application. Analytics provider for risk management.

Valuation explanations link to Wikipedia

Harvard, others suffer massive losses on swaps

"Harvard University’s failed bet that interest rates would rise cost the world’s richest school at least $500 million in payments to escape derivatives that backfired.

Harvard paid $497.6 million to investment banks during the fiscal year ended June 30 to get out of $1.1 billion of interest-rate swaps intended to hedge variable-rate debt for capital projects, the report said. The university in Cambridge, Massachusetts, said it also agreed to pay $425 million over 30 to 40 years to offset an additional $764 million in swaps.

The transactions began losing value last year as central banks slashed benchmark lending rates, forcing the university to post collateral with lenders, said Daniel Shore, Harvard’s chief financial officer. Some agreements require that the parties post collateral if there are significant changes in interest rates.

“When we went into the fall, we had some serious liquidity management issues we were dealing with and the collateral postings on the swaps was one,” Shore said in an interview today. “In evaluating our liquidity position, we wanted to get some stability and some safety.”

Harvard sold $2.5 billion in bonds in the fiscal year, in part to pay for the swap exit, even as the school’s endowment recorded its biggest loss in 40 years, the annual report said. This is the first time the university has detailed the cost of exiting its swaps.

Further Pressure

“Substantial losses” in Harvard’s General Operating Account, a pool of cash from which bills are paid, further put pressure on the school, the report said. The net asset value of the account fell to $3.7 billion from $6.6 billion during the fiscal year, according to the report.

Harvard has typically invested a large portion of this operating account alongside the endowment, generating “significant positive investment results,” the report said. This year, the endowment’s losses hurt Harvard’s cash, according to the report.

Swaps are a type of derivative where two parties agree to exchange payments tied to a financing, typically receiving a variable-rate for a fixed-rate payment. The terminated contracts include three tied to $431.7 million of bonds the university sold in 2005 and 2007, the annual report said.

Unwinding Swaps

From New York to San Francisco Bay, tax-exempt issuers have paid hundreds of millions of dollars to unwind bond-and-swap transactions officials initially said would cut borrowing costs. The deals fell apart when municipal-bond insurers, who backed much of the underlying debt, lost their AAA ratings in 2008 and interest rates, instead of climbing, plunged to record lows in the worst credit crisis since the Great Depression.

The swaps are often pegged to Securities Industry and Financial Markets Association lending benchmarks or the three- month dollar London-Interbank Offered Rate, known as Libor. Libor closed today at 0.28 percent, from a 10-year high of 6.89 percent on June 1, 2000.

Yale University in New Haven, Connecticut; Georgetown University in Washington and Rockefeller University in New York have reported losses related to interest-rate swaps, in some cases prompting the schools to pay termination fees to end the contracts.

Lawrence Summers

The annual report provides new details on Harvard’s derivative-related losses. Many were entered into in 2004, said Harvard spokeswoman Christine Heenan. Lawrence Summers, director of President Barack Obama’s National Economic Council, was the university’s president at the time. White House spokesman Matthew Vogel declined to comment.

Harvard Management Co., which administers the endowment, has been run since July 2008 by Jane Mendillo, former chief investment officer of nearby Wellesley College. She took over from Mohamed El-Erian, now chief executive officer of Pacific Investment Management Co., which oversees the world’s largest bond fund from Newport Beach, California. He succeeded Jack Meyer, who ran it for 15 years, in February 2006.

Harvard’s loss “says that people don’t understand the complexity of the products they are buying and selling and that doesn’t begin and end with mortgage securities,” said Robert Doty, a municipal finance adviser at American Governmental Services in Sacramento, California.

“It shows that with these products that are so highly complex, people are a long way from knowing as much about these products as they think they do,” he said.

Financing Construction

The Harvard swaps involved bonds sold to finance a medical research building, graduate housing, parking and a Center for Government and International Studies, according to reports from Moody’s Investors Service. They were also used to lock in rates for future bond sales for an expansion of the campus across the Charles River in Boston that has since been scaled back.

Harvard had 19 swap contracts with New York-based Goldman Sachs; JPMorgan Chase & Co.; Morgan Stanley; Charlotte, North Carolina-based Bank of America Corp. and other large banks, according to a bond-ratings report by Standard & Poor’s released on Jan. 18, 2008.

Harvard paid “a large termination fee, but within the range that we’ve heard about over the last year,” Matt Fabian, the senior analyst and managing director of Municipal Market Advisors in Westport, Connecticut, said in an e-mail. “There is a reason why, regardless of the issuer’s sophistication, there should be limits to their exposure to derivatives and variable rate bonds.”

Harvard has frozen employee salaries, slowed hiring, cut staff and offered other workers early retirement as part of a cost-cutting program to compensate for losses in its endowment. The fund, which dropped to $26 billion in value over the fiscal year from $36.9 billion, paid 38 percent of the school’s bills during that time, the report said.

Alumni Request

The Faculty of Arts and Sciences, Harvard’s biggest unit, which includes its undergraduate school, is asking alumni and donors for more funds that can be used immediately and without restrictions to help close a projected $110-million deficit in its 2011 budget, Dean Michael Smith said in a recent speech. Current-use gifts rose 23 percent to $291 million from $237 million in fiscal 2008, the report said.

Harvard might have paid less to escape the swaps if it held out for better terms, Fabian said.

“A lot of issuers don’t have that kind of cash, and so they waited, and relied on their dealers’ patience and largesse to hold off terminating,” Fabian said. “If Harvard had waited, the cost of terminating may well have been lower, but they weren’t willing to take that risk.”


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